Financial ratios are calculations that express the relationship between two figures taken from a company's financial statements, such as current assets divided by current liabilities, or net income divided by sales. By turning raw amounts into proportions, ratios make it possible to compare a business with its own past, with competitors of different sizes and with industry norms. They are the main tool of financial statement analysis.
Ratios are used by lenders deciding whether to extend credit, investors valuing shares, managers tracking performance, and auditors looking for unusual movements. Loan agreements often set minimum or maximum ratios as covenants. Ratios are usually grouped into liquidity, solvency, profitability, efficiency and market measures, each answering a different question about the business.
Financial ratios in plain terms
Knowing that one shop made $50,000 profit and another made $500,000 tells you little on its own. If the first shop sold $200,000 of goods and the second sold $10 million, the small shop is actually earning far more on each dollar of sales. Ratios put numbers in proportion so that comparisons make sense.
A doctor reading blood test results does something similar. No single figure tells the whole story, but a set of measures, each compared with a normal range, shows where a patient is healthy and where there may be a problem. Financial ratios are the business version of those test results.
Main types of financial ratios
| Group | Question answered | Examples |
|---|---|---|
| Liquidity | Can the business pay its bills in the short term? | Current ratio; acid-test ratio |
| Solvency | Can it meet long-term debts and interest? | Debt-to-equity; times interest earned |
| Profitability | How much profit does it earn on sales and capital? | Gross profit percentage; return on assets; return on equity |
| Efficiency | How well does it use its assets? | Inventory turnover; receivables turnover |
| Market | How do investors value its shares? | Earnings per share; price-earnings ratio |
Key ratios and how they are calculated
- The current ratio divides current assets by current liabilities. The stricter acid-test ratio leaves out inventory and prepaid items, counting only cash, marketable securities and receivables.
- The debt-to-equity ratio divides total liabilities by stockholders' equity, showing how heavily the business relies on borrowing. Times interest earned divides earnings before interest and taxes by interest expense.
- The gross profit percentage divides gross profit by net sales. Return on assets divides net income by average total assets, and return on equity divides net income by average stockholders' equity.
- The inventory turnover ratio divides cost of goods sold by average inventory. The accounts receivable turnover ratio divides net credit sales by average receivables.
- Earnings per share divides net income available to common shareholders by the weighted average number of common shares, and the price-earnings ratio divides the share price by earnings per share.
Worked example
A wholesaler reports current assets of $300,000, including $120,000 of inventory, and current liabilities of $150,000. Its current ratio is 300,000 divided by 150,000, or 2.0, and its acid-test ratio is 180,000 divided by 150,000, or 1.2. Net sales were $1,200,000, gross profit $360,000, net income $60,000, and average equity $400,000. The gross profit percentage is 30 percent and return on equity is 15 percent. Cost of goods sold of $840,000 divided by average inventory of $105,000 gives inventory turnover of 8 times a year.
On their own these numbers mean little. They become useful when compared with the same company's earlier years, using horizontal analysis, and with similar businesses in the same industry.
Limitations
Ratios are only as reliable as the figures behind them. Different accounting methods, such as FIFO versus LIFO or different depreciation policies, can make similar companies look different. Year-end balances may not represent the rest of the year, especially for seasonal businesses, and some companies time transactions to improve ratios at the reporting date. Inflation, one-off items and differences in business models also distort comparisons. Ratios point to questions worth asking; they rarely answer them on their own, and they are best read together with the notes, the cash flow statement and an understanding of the industry.